Law’s Economic Dynamics

Guest Author: David M. Driesen

What caused the financial crisis? Clearly massive financial deregulation played a key role. Without it, almost everything done to create the financial crisis would have been illegal  And a failure to establish adequate standards has begun to create a climate crisis as well, as evidenced most recently by the freak storm called Sandy, which wreaked havoc in the northeastern United States (traditionally not a hurricane-prone area) in late October (well past normal hurricane season).  But why have we engaged in deregulation when we face potential catastrophes that demand proactive government?

The Economic Dynamics of Law (Cambridge University Press 2012) shows that the conventional approach to law and economics, usually called neoclassical or Chicago-School law and economics, helped create the climate of ideas that made destructive deregulation possible. Prominent economists have made that point before me, but they have not explained how we should rethink law and economics to support a climate of ideas hospitable to sensible legal reform. The Economic Dynamics of Law fills the gap.

First, we need to change how we think about law’s goals. It may seem obvious that government’s most fundamental role involves helping us avoid what economists call “systemic risk,” risks of catastrophes that destroy economic, ecological, or social systems. We cannot expect government to ensure everybody’s happiness or to act in a perfectly efficient manner. But government must, at a bare minimum, secure its citizens against man-made catastrophes.

Oddly enough, neoclassical law and economics has turned its back and even undermined pursuit of this basic goal.  It demands an excessive preoccupation with making government action “allocatively efficient,” meaning that every step government takes should balance costs and benefits. Cost-benefit analysis however, does not work very well when it comes to difficult to predict phenomena like the extent of climate disruption damages or the precise GNP loss a financial crisis will create. And bean counting distracts us from understanding and responding efficaciously to dynamic problems like terrorism, climate disruption, and a potential financial crisis. Since cost-benefit analysis is often impossible and always very incomplete when focused on key government policies, practitioners of neoclassical law and economics have usually not even bothered. Instead, they often assume that market actors act rationally based on perfect information and therefore most government regulation is unnecessary. That kind of wishful thinking motivated the financial deregulation that started the financial crisis.

In addition to making avoiding systemic risk a major goal, we need to focus on the shape of change over time. Law’s proper focus is on countervailing important negative trends. We put laws in place when we see that a serious problem needs fixing and laws usually remain in place for a long time and therefore influence our future. Neoclassical law and economics, however, treats law as if it were a mere transaction, just like a market purchase. This is too narrow and short- sighted a focus and neglects law’s role as providing a framework for transactions, much as macroeconomic policies (like government set interest rates) do.

Finally, in order to avoid systemic risks effectively, we need to employ economic dynamic analysis to guide our actions. This form of institutional economic analysis involves systematic evaluation of economic incentives to detect brewing problems and design appropriate safeguards. Several economists and legal scholars used economic dynamic analysis to predict the financial crisis. And the policymakers who rescued the banks, thereby preventing an even worse crisis from occurring, did so because they understood that the crisis had unleashed an economic dynamic that could bring down the entire economy.

The Economic Dynamics of Law shows how the economic dynamic approach helps us to better understand and reform not just financial regulation, climate disruption law, and counterterrorism law, but also intellectual property, antitrust, contract, and property law. In all of these contexts the goal of avoiding systemic risk while keeping open a robust set of economic opportunities, a focus on the shape over time, and employment of economic dynamic analysis provide a means of sensibly addressing key policy issues.

David M. Driesen is a University Professor at Syracuse University and a member scholar of the Center for Progressive Reform. He is the author of The Economic Dynamics of Law (Cambridge University Press 2012).  He researches and has taught environmental law, law and economics, and constitutional law. Professor Driesen’s first book, The Economic Dynamics of Environmental Law, won the Lynton Keith Caldwell Award, a prize offered by The American Political Science Association annually for the best book published in science, technology and environmental studies.

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